Compound interest can really pay

This week was the first real test for shares, and investors clearly liked what they saw.

The reporting season has so far delivered the earnings some had hoped for when they snapped up those high-dividend defensive stocks last year.

And those dividends are a timely reminder about the power of compound interest and what sort of effect it can have on a portfolio over time when a stockmarket is rising.

Every smart investor knows that buying blue-chip companies and reinvesting the dividends can turn thousands of dollars into hundreds of thousands and more.

But, as always, timing is everything.

According to Perpetual, $100 invested in shares in 1901 and reinvested each year would be worth $26.6 million today, while the same amount of money put into a cash account, for safety first reasons, would be worth only $79,290.

Based on the headline inflation rate, that $100 at the start of 1901 is roughly the equivalent of $6730 today.

AMP Capital Investors’ Shane Oliver has also crunched some numbers, but his starting point is 1926.

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If investors put $100 into shares back then and reinvested any dividends, it would be worth around $1.64 million today.

That’s the power of compound interest, and those numbers show the difference between starting to invest in 1901 and 1926 ended up being around $25 million.

Don Stammer, the former chief economist at Bain & Co, used to say that most people didn’t understand compound interest until they were 55 and by then it was too late.

Schroder Investment Management’s portfolio manager, Marcus Burns, has also studied the power of compound interest but he has looked at a shorter time frame that still shows just how powerful it can be.

It also shows the importance of buying the right asset.

Burns reckons a Porsche bought for around $212,000 in 1987 is now worth about $20,000, delivering the owner a compound return of minus 9.4 per cent per annum.

In contrast, if investors had spent that same amount of money on shares in
National Australia Bank
or
BHP Billiton
they would have $4.5 million and $5.4 million respectively.

That’s an annual compound return of 13 per cent and 13.8 per cent. As he points out, a small difference in compounding rates adds up to a very large difference over time.

Over a 25-year time frame, the difference between a 10 per cent per annum return and a 13 per cent per annum return can be double.

But the problem for many self-directed investors is that short-term returns are front of mind for most people and can have more influence on investment decisions than long-run returns.